Forbes – As David Rubenstein of Carlyle Group once succinctly remarked, “If you can make 20 percent of the profits on other people’s money, you are going to make a lot of money if you are good at what you do.” Never have truer words been spoken about the underlying structure and operation of incentives in the financial markets.
Performance-based compensation can be viewed as a call option that permits a fund manager to benefit from a rise in the value of the fund. The purpose is to incentivise managers for absolute returns, rather than simply tracking (and periodically beating) a benchmark like the S&P 500 or the FTSE 100. However, performance fees and carried interest can also have a potentially negative influence on risk-taking. As overall performance of a fund declines, for example, a particularly greedy fund manager may be motivated in the short term to increase the risk of investments to move his call option back “in-the-money”. Steps can be taken, however, to mitigate this risk-taking behaviour.
